For years free-market economists have protested the waste and abuse of foreign aid programs, International Monetary Fund loans, and World Bank projects.(1) P.T. Bauer has been in the forefront as a dissenter against government development programs. For the past 50 years, he has argued forcefully that government assistance in developing nations only retards economic growth.(2)

But if IMF lending, foreign aid, and the World Bank are abolished, what should be done to alleviate poverty? Bauer and other classical liberals advocate reducing trade barriers; increasing foreign investment; establishing property rights, the rule of law, and a stable monetary policy; and encouraging free markets and limited government domestically.

Private-Sector Micro Lending

Yet market advocates have been surprisingly silent on a burgeoning private-sector success story known as “micro lending,” the lending of extremely small amounts of money to self-employed entrepreneurs in the Third World by independent banks and institutions. The most famous of these micro-lenders is the Grameen Bank, founded by Muhammad Yunus in Bangladesh, the world’s poorest country, in 1983. Yunus is an economics pro- fessor at Chittagong University in Bangladesh.

When I say “small loans,” I mean minuscule. The Grameen Bank lends only $30 to $200 per borrower. Applicants don’t have to read or write to qualify. No collateral or credit check is required. Amazingly, the Grameen Bank has made these micro loans to millions of poverty-stricken people in Bangladesh, $2.5 billion so far. These loans are not interest-free. The Grameen Bank is a for-profit private-sector self-help bank that charges 18 percent interest rates. The default rate? Less than 2 percent. This remarkable record is due to the requirement that borrowers must join small support groups. If anyone in the group defaults, no one else can borrow more.

The bank lends to entrepreneurs, overwhelmingly female, who need only a few dollars to buy supplies and tools. Borrowers might be makers of bamboo chairs, sellers of goat’s milk, or drivers of rickshaws. By avoiding the outrageous rates charged by other money-lenders (often 20 percent a month), these people are finally able to break the cycle of poverty. Their small businesses grow, and some use their profits to build new homes or repair existing ones (often using a $300 Grameen house loan). Thousands of Grameen borrowers now own land, homes, and even cell phones. And they are no longer starving. Yunus has plans to issue private stock and eventually go public with his antipoverty program.

His bank has been so successful that other micro-lending institutions have sprung up throughout the world. The concept has gained credence everywhere, to the point that even the World Bank and other government agencies have gotten into the million-dollar micro-loans business.

Saying No to the World Bank

But Yunus won’t have anything to do with the World Bank. In his new autobiography, Banker to the Poor (highly recommended), Yunus decries the World Bank: “We at the Grameen Bank have never wanted or accepted World Bank funding because we do not like the way the bank conducts business.” Nor does he much like foreign aid: “Most rich nations use their foreign aid budgets mainly to employ their own people and to sell their own goods, with poverty reduction as an afterthought. . . . Aid-funding projects create massive bureaucracies, which quickly become corrupt and inefficient, incurring huge losses. . . . Aid money still goes to expand government spending, often acting against the interests of the market economy. Foreign aid becomes a kind of charity for the powerful while the poor get poorer.”(3) Peter Bauer couldn’t have said it better.

From Marxism to Marketism

Yunus’s statements are all the more amazing given that he grew up under the influence of Marxist economics. But after getting a Ph.D. in economics at Vanderbilt University he saw firsthand “how the market [in the United States] liberates the individual” and rejected socialism. “I do believe in the power of the global free-market economy and in using capitalist tools. . . . I also believe that providing unemployment benefits is not the best way to address poverty.” Believing that “all human beings are potential entrepreneurs,”Yunus is convinced that poverty can be eradicated by lending poor people the capital they need to engage in profitable businesses, not by giving them a government handout or engaging in population control. His former Marxist colleagues call it a capitalist conspiracy. “What you are really doing,” a communist professor told him, “is giving little bits of opium to the poor people. Their revolutionary zeal cools down. Therefore, Grameen is the enemy of the revolution.”(4) Precisely.

The Chicago boys are at it again. This time the economists at the University of Chicago are making headlines in today’s hotly disputed debate about gun control. Milton Friedman set the general standard a generation ago by insisting on rigorous empirical work to support sound (though often unpopular) theory and policy. More recently, Gary Becker extended Chicago-style economic analysis into contemporary social problems such as education, marriage, discrimination, professional sports, and crime.

Now John R. Lott, Jr., until recently the John M. Olin Law and Economics Fellow at Chicago, is making the case that a well-armed citizenry discourages violent crime. Lott analyzed the FBI’s massive yearly crime statistics for all 3,054 U.S. counties over 18 years, the largest national surveys on gun ownership, and state police documents on illegal gun use. His surprising conclusions, published in his recent book, More Guns, Less Crime:

States now experiencing the largest drop in crime are also the ones with the fastest-growing rates of gun ownership.

The Brady five-day waiting period, gun buy-back programs, and background checks have little or no impact on crime reduction.

States that have recently allowed concealed weapon permits have witnessed signif- icant reductions in violent crime.

Guns are used on average five times more frequently in self-defense than in committing a crime.(2)

According to Lott, recent legislative efforts to restrict gun ownership may actually keep many law-abiding citizens from protecting themselves from attack. (There’s that Law of Unintended Consequences again.)

The Incentive Principle Underlining

Lott’s findings is a basic eco- nomic concept, the law of demand: If the price of a commodity goes up, people use less of it. In the case of criminal activity, if the cost and risk of committing a crime rises, less crime will be committed. This is often referred to as the market’s incentive principle.

Gary Becker has showed that increasing the cost of crime through stiffer jail sentences, quicker trials, and higher conviction rates effectively reduces the number of criminals who rob, steal, or rape.(3)

Similarly, Lott argues that state laws permitting concealed handguns deter crime. “When guns are concealed, criminals are unable to tell whether the victim is armed before striking, which raises the risk to criminals.” (4) He produces a variety of statistics and graphs to support his case. For example, the following graph compares the average number of violent crimes in states before and after the adoption of a concealed-handgun law.

Lott’s crime figures also remind me of Frederic Bastiat’s brilliant essay “What Is Seen and What Is Not Seen.” In 1850, this great French journalist wrote, “In the economic sphere,. . . a law produces not only one effect, but a series of effects. Of these effects, the first . . . is seen. The other effects emerge only subsequently; they are not seen.”(5)

According to Lott, Bastiat’s principle applies in crime statistics. “Many defensive uses [of guns] are never reported to the police.”(6) Lott gives two reasons. First, in many cases of self-defense, a handgun is simply brandished, the assailant backs off, and no one is harmed. Second, in states that have stringent gun laws, cit- izens who use a gun for protection fail to report the incident for fear of being arrested by the police for illegal use of a weapon. Thus, Lott confirms (through extensive surveys) the initial work of Gary Kleck, professor of criminal justice at Florida State University, that guns are used far more frequently in self-defense than in committing crimes. Kleck, by the way, used to have a strong anti-gun bias until he uncovered this revealing statistic.

All this confirms a long-standing constitutional principle: People have the right to own a gun for self-protection.

“Keynes . . . misunderstood and misrepresented Say’s Law. . . . This is Keynes’s most enduring legacy and it is a legacy which has disfigured economic theory to this day.”
—Steven Kates[1]

In researching my forthcoming book, The Story of Modern Economics (to be published by M. E. Sharpe next year), I came across a remarkable new work by Australian economist Steven Kates, Say’s Law and the Keynesian Revolution. According to Kates, John Maynard Keynes created a straw man in order to produce a revolution in economics. The straw man was Jean-Baptiste Say and his famous law of markets. Steven Kates calls The General Theory “a book-length attempt to refute Say’s Law.”

But to refute Say’s Law, Keynes gravely distorted it. As Kates states, “Keynes was wrong in his interpretation of Say’s Law and, more importantly, he was wrong about its economic implications.”[2] And Kates is sympathetic to Keynesian economics!

How Keynes Got It Wrong

In the introduction to the 1939 French edition of The General Theory, Keynes focused on Say’s Law as the central issue of macroeconomics. “I believe that economics everywhere up to recent times has been dominated . . . by the doctrines associated with the name of J.-B. Say. It is true that his ‘law of markets’ has long been abandoned by most economists; but they have not extricated themselves from his basic assumptions and particularly from his fallacy that demand is created by supply. . . . Yet a theory so based is clearly incompetent to tackle the problems of unemployment and of the trade cycle.”

Unfortunately, Keynes failed to understand Say’s Law. By incorrectly stating it as “supply creates its own demand,” he proposed, in effect, that Say meant that everything produced is automatically bought. Hence, Say’s Law cannot explain the business cycle.[3]

Keynes went on to say that the classical model under Say’s Law “assumes full employment.” Other Keynesians have continued to make this point, but nothing could be further from the truth. Conditions of unemployment do not prohibit production and sales from taking place that form the basis of new income and new demand.

Moreover, Say’s Law specifically formed the basis of a classical theory of the business cycle and unemployment. As Kates states, “The classical position was that involuntary unemployment was not only possible, but occurred often, and with serious consequences for the unemployed.”[4]

Production and Consumption

Exactly what is Say’s Law? Chapter 15 of Say’s A Treatise on Political Economy describes his famous law of markets: “A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value.”[5] When a seller produces and sells a product, the seller instantly becomes a buyer who has spendable income. To buy, one must first sell. In other words, production is the cause of consumption, and increased output leads to higher consumer spending.

In short, Say’s Law is this: The supply (sale) of X creates the demand for (purchase of) Y.

Say illustrated his law with the case of a good harvest by a farmer. “The greater the crop, the larger are the purchases of the growers. A bad harvest, on the contrary, hurts the sale of commodities at large.”[6]

Say has a point. According to business-cycle statistics, when a downturn starts, production is the first to decline, ahead of consumption. And when the economy begins to recover, it’s because production starts up, followed by consumption. Economic growth begins with an increase in productivity, new products, and new markets. Hence, production spending is always ahead of consumption spending.

We can see why this is the case on an individual basis. The key to a higher standard of living is, first, an increase in your income, that is, your productivity, either by getting a raise, changing jobs, going back to school, or starting a money-making business. It would be foolish to achieve a higher standard of living by spending savings or going into debt to buy a bigger house or new automobile before you increase your productivity. You may be able to live high on the hog for a while, but eventually you will have to pay the piper . . . or the credit card bill.

According to Say, the same principle applies to nations. The creation of new and better products opens up new markets and increases consumption. Hence, “the encouragement of mere consumption is no benefit to commerce; for the difficulty lies in supplying the means, not in stimulating the desire of consumption; and we have seen that production alone, furnishes those means.” Then Say added, “Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.”[7]

The Cause of the Business Cycle

Say’s Law states that recessions are not caused by failure of demand (Keynes’s thesis), but by failure in the structure of supply and demand. Recession is precipitated by producers miscalculating what consumers wish to buy, thus causing unsold goods to

pile up, production to be cut back, income to fall, and finally consumer spending to drop. As Kates elucidates, “Classical theory explained recessions by showing how errors in production might arise during cyclical upturns which would cause some goods to remain unsold at cost-covering prices.” The classical model was a “high-sophisticated theory of recession and unemployment” that with one fell swoop by the illustrious Keynes was “obliterated.”[8]

In his broad-based book, Kates highlights other classical economists, including David Ricardo, James Mill, Robert Torrens, Henry Clay, Frederick Lavington, and Wilhelm Röpke, who extended Say’s Law. Many classical economists focused on how monetary inflation exacerbated the business cycle. They were precursors of the Austrians Ludwig von Mises and F.A. Hayek.

Free-market economists, such as W. H. Hutt and Thomas Sowell, have tried to rehabilitate Say’s Law, but none carries the punch of Steven Kates.

“Hawaii’s great and beloved landmark … is too precious an asset to be sacrificed.”–Honolulu Advertiser editorial ( 1967)

Last month I addressed the theory of entrepreneurial error in conjunction with the year 2000 computer problem. This month I raise another issue dealing with the possibility of market failure: Should government protect a local landmark from commercial development? Are zoning laws and other building restrictions necessary in a free society to stop “greedy” speculators and “fast buck” promoters from creating “urban sprawl” and unsightly commerce?

Recently my family and I spent a few days in Hawaii. Walking along famed Waikiki Beach, I couldn’t help noticing how a string of high-rise apartments and hotels halted abruptly along the Diamond Head shoreline.

The Story of Diamond Head

Why the sudden abatement? In the late 1960s Diamond Head was the center of a fierce debate between the developers and the conservationists. Following statehood in 1959, tourists flocked to this paradise of the Pacific, and Waikiki Beach, sandwiched between downtown Honolulu and Diamond Head, became the hottest real estate market for resort hotels and condominiums. Honolulu newspapers ran photos of a rapidly disappearing view of Diamond Head, and local citizens became alarmed. A grassroots organization, Save Diamond Head Association, was formed in 1967 and demanded a halt to building any more skyscrapers along the shoreline.

Why save Diamond Head? In the nineteenth century, British sailors found crystalline rocks on its slopes and mistook them for diamonds. Conservationists argue that Diamond Head is a symbol of paradise, the mid-Pacific’s most famous beacon. One visitor wrote during the debate, “I found Diamond Head, which has been declared a state monument, in imminent danger of turning into a monument for the fast buck, its craggy profile threatened with disappearance behind a palisade of tall concrete buildings.”1

Here’s the conflict: Hawaii’s natural beauty and delightful climate attracted millions of new tourists in the 1960s. The tourist boom in turn created a rush in real estate development. But the high-rise buildings along with enormous billboards-were blocking out the natural beauty that attracted tourists in the first place. What to do?

The fight between the developers and environmentalists came to a head in December 1967. After a packed four-hour public hearing, five members of the nine-member city council voted against further commercial development. The other four members abstained. In 1968, Diamond Head was designated an official national landmark.

Is There a Market Solution?

Could the market properly plan for a growing Hawaii without destroying its natural beauty and aloha spirit, or must government intervene?

Sometimes the market faces a difficult choice between two conflicting goals. In the case of Diamond Head, it was the battle between development and a landmark symbol. Unfortunately, it’s events like these that give capitalism a bad name. Could private developers have done better? Could it have been in their own self-interest to limit the height of hotels and condos and preserve Oahu’s historic skyline while still making a profit? Can progress and profit go together?

What do free-market economists have to say about zoning and building codes? In The Constitution of Liberty, FA Hayek notes that local governments have often done a poor job of city planning, sometimes amounting to “administrative despotism.”2 He cites rent controls, zoning regulations, and excessive taxation as examples. Nevertheless, he does support “some regulation of buildings permitted in cities,” including minimum building codes.3

Economists have often been critical of zoning laws as an infringement of property rights. In a recent book on the subject, Tom Bethell asserts that zoning laws hurt the poor, cause urban sprawl, and invite political corruption. He points to Houston as an example of a dynamic city which has grown without zoning regulations.4

If conservationists really wanted to save Diamond Head, why didn’t they buy the shoreline property and keep developers out? Instead of running to the City of Honolulu, Save Diamond Head Association should have raised the capital to stave off builders. Since 1953, Nature Conservancy, a nonprofit environmental organization with 900,000 members, has been buying and preserving land and habitats (now totaling over 10 million acres in the United States). Of course, such a plan would have been costly, with Waikiki property prices around $1 million an acre in 1967-68.

Property rights should include the right to be left alone from noise and air pollution. Should these rights also include the right of original owners to view Diamond Head?

1. Kenneth Lamott, Holiday Magazine, July 14, 1967, quoted in Helen Geracimos Chapin, Shaping History. The Role of Newspapers in Hawaii (Honolulu: University of Hawaii Press, 1996), p. 268. Chapter 26 of Chapin’s book, “Above Ground: The Battle for Diamond Head,” summarizes the history of this conflict through the eyes of two local newspapers, the Star-Bulletin and the Advertiser.

2. F.A. Hayek, The Constitution of Liberty (Chicago: University of Chicago Press, 1960), p. 355. Hayek devotes an entire chapter to “Housing and Town Planning,” an area often ignored by economists.

“No businessman in the real world is equipped with perfect foresight; all make errors.”
–Murray N. Rothbard (1)

Over the past year, I’ve been involved in a series of debates over the impact of the Year 2000 Problem, the potential collapse of computers–and perhaps the economy–owing to the fact that since computer programs use two digits instead of four to indicate years, the year 2000 will be treated as 1900. On the one extreme is Gary North, who claims that the Y2K problem is so serious that it will gravely disrupt society for years. On the other end is Harry Browne, who says that enlightened entrepreneurs will avert a worldwide disaster.

What’s interesting about the debate is that free-market advocates are found on both sides. North and other naysayers focus on the propensity of market players to make entrepreneurial errors and engage in shortsightedness. Browne and other optimists stress the entrepreneurs’ ability to solve problems, especially when so much is at stake. (Some businesses could go bankrupt if they don’t address the Y2K problem.) In short, the market works.

My concern is that the “market always works” camp comprises true believers who blindly think the market can solve all problems almost automatically. They seem to fit into the rational equilibrium-always school of economics where entrepreneurial misjudgment, imperfect knowledge, and uncertainty play little or no role.

MARKETS ARE NOT PERFECT

The Austrian economists teach otherwise. Israel Kirzner, noted for his studies on entrepreneurship, attacks the model of perfect efficiency as “wholly unsatisfying.” He adds that, “It is most embarrassing to have to grapple with the grossly inefficient world we know with economic tools that assume away the essence of the problem with which we wish to deal.” (2)

The market is characterized by profit and loss, success and failure, certainty and uncertainty. There is always room for improvement, and the entrepreneur’s role is to eliminate errors and inefficiencies. Thus, it should come as no surprise that many businesses and financial institutions are making significant headway in fixing their computer programs to avert the Y2K problem.

On the other hand, it would be folly to ignore that many businesses have budgeted insufficient time and money to fix or replace their computers. Evidence is growing that most firms, especially small businesses, are not doing enough. Many major corporations and government agencies, both here and abroad, admit that they only have time to fix critical systems. The rest will fail on January 1, 2000.

Free-market advocates sometimes place too mcuh faith in the market’s ability to solve problems and ignore ubiquitous error in an entrepreneurial economy. Think about all the ways people make mistakes every day in the marketplace: Investors buy the wrong stock. Businessmen declare bankruptcy. Marriages break up. Consumers over-spend and over-eat, especially during the holidays. Kids fail to do homework. Drivers have accidents. Ships sink. Builders don’t meet deadlines. Economists make false predictions. Entrepreneurs cut corners, deceive customers, and embezzle funds. Economic failure, stupidity, and incompetence are common to human nature. As Ludwig von Mises noted, “To make mistakes in pursuing one’s ends is a widespread human weakness.” (3)

The decision by computer programmers in the early 1950s to use two digits instead of four is a classic example of individual shortsightedness. To save space, they cut corners, and now, a generation later, the whole world is paying a heavy price for their blunder.

CLUSTER OF ERRORS

In most cases, entrepreneurial error is random, unpredictable, and self-correcting. As Murray Rothbard states, “As a rule only some businessmen suffer losses at any one time; the bulk either break even or earn profits.” (4)

There are, however, cases of widespread error–mistakes that affect virtually every part of an industry or economy. Rothbard, in standard Austrian school fashion, explained depressions in terms of “a sudden general cluster of business errors.” (5) Of course, the Austrians attribute those errors and the business cycle in general to monetary inflation by government.

Yet can’t error with far-reaching harm occur in the market without government being responsible? Austrian economists don’t normally discuss this possibility, but it undoubtedly exists. Market decision-makers have made shortsighted blunders that have had universal consequences. Examples of such errors include asbestos in construction, pesticides in agriculture, and air and water pollution in manufacturing. The Y2K computer glitch is a particularly tough challenge because it is universal and time-sensitive. In most cases, the deadline cannot be postponed.

THE MARKET’S SELF-CORRECTING MECHANISM

Fortunately, the market has a built-in mechanism to minimize mistakes and entrepreneurial error. The market penalizes mistakes and rewards correct behavior. Business leaders know that computer problems can destroy their business; fixing the Y2K bug will avoid losses and may even be profitable. They are willing to pay the price. As Kirzner has said, “Pure profit opportunities exist whenever error occurs.” (6) At the same time, the market will severely penalize businesses that have ignored the Y2K problem or have procrastinated.

Followers of free markets should take note: markets may be self-correcting, but they are not all-seeing.

3. Ludwig von Mises, Theory and History (Yale University Press, 1957), p. 268. Mises adds that “Error, inefficiency, and failure must not be confused with irrationality. He who shoots wants, as a rule, to hit the mark. If he misses it, he is not ‘irrational'; he is a poor marksman.”

“A free gold market … reflects and measures the extent of the lack of confidence in the domestic currency.”– LUDWIG VON MISES

In the past two columns, I’ve highlighted the uses and misuses of gold. Despite occasional calls for a return to a gold standard, the Midas metal has largely lost out to hard currencies as a preferred monetary unit and monetary reserve. Most central banks are selling gold.

Gold has also done poorly as a crisis hedge lately. It has not rallied much during recent wars and international incidents. U.S. Treasury securities and hard currencies such as the German mark and Swiss franc have become the investments of choice in a flight to safety.

Nor has gold functioned well as an inflation hedge over the past two decades. The cost of living continues to increase around the world, yet the price of gold has fallen from $800 an ounce in 1980 to under $300 today.

What’s left for the yellow metal? I see two essential functions for gold: first, a profitable investment when general prices accelerate and, second, an important barometer of future price inflation and interest rates.

Gold as a Profitable Investment

Since the United States went off the gold standard in 1971, gold bullion and gold mining shares have become well-known cyclical investments. The first graph demonstrates the volatile nature of gold and mining stocks, with mining shares tending to fluctuate more than gold itself. The gold industry can provide superior profits during an uptrend, and heavy losses during a downtrend.

One of the reasons for the high volatility of mining shares is their distance from final consumption. Mining represents the earliest stage of production and is extremely capital intensive and responsive to changes in interest rates.1

Gold as a Forecaster

Gold also has the amazingly accurate ability to forecast the direction of the general price level and interest rates. In an earlier Freeman column (February 1997), I referred to an econometric model I ran with the assistance of John List, economist at the University of Central Florida. We tested three commodity indexes (Dow Jones Commodity Spot Index, crude oil, and gold) to determine which one best anticipated changes in the Consumer Price Index (CPI) since 1970. It turned out that gold proved to be the best indicator of future inflation as measured by the CPI. The lag period is about one year. That is, gold does a good job of predicting the direction of the CPI a year in advance. (All three indexes did a poor job of predicting changes in the CPI on a monthly basis.)

Richard M. Salsman, economist at H. C. Wainwright & Co. in Boston, has also done some important work linking the price of gold with interest rates. As the second graph demonstrates, the price of gold often anticipates changes in interest rates in the United States. As Salsman states, “A rising gold price presages higher bond yields; a falling price signals lower yields. … Gold predicts yields well precisely because I~ it’s a top-down measure. It is bought and sold based purely on inflationdeflation expectations; thus it’s the purest barometer of changes in the value of the dollar generally.”2

In sum, if you want to know the future of inflation and interest rates, watch the gold traders at the New York Mere. If gold enters a sustained rise, watch out: higher inflation and interest rates may be on the way.

1. For further discussion regarding the inherent volatility of the mining industry, see my work The Structure of Production (New York: New York University Press, 1990), pp. 290-94.

“Gold maintains its purchasing power over long periods of time, for example, half-century intervals.”
Rou JASTRAM, The Golden Constant1

In last month’s column, I focused on gold’s inherent stability as a monetary numeraire. Historically, the monetary base under gold has neither declined nor increased too rapidly. In short, it has operated very closely to a monetarist rule.

What about gold as an inflation hedge? In this column, I discuss the work of Roy Jastram and others who have demonstrated the relative stability of gold in terms of its purchasing power–its ability to maintain value and purchasing power over goods and services over the long run. But the emphasis must be placed on the “long run.” In the short run, gold’s value depends a great deal on the rate of inflation and therefore often fails to live up to its reputation as an inflation hedge.

The classic study on the purchasing power of gold is The Golden Constant: The English and American Experience, 1560-1976, by Roy W. Jastram, late professor of business at the University of California, Berkeley. The book, now out of print, examines gold as an inflation and deflation hedge over a span of 400 years.

Two Amazing Graphs

The accompanying two charts are from Jastram’s book and updated through 1997 by the American Institute for Economic Research in Great Barrington, Massachusetts. They tell a powerful story:

First, gold always returns to its full purchasing power, although it may take a long time to do so; and

Second, the price of gold became more volatile as the world moved to a fiat money standard beginning in the 1930s. Note how gold has moved up and down sharply as the pound and the dollar have lost purchasing power since going off the gold standard.

In my economics classes and at investment conferences, I demonstrate the long-term value of gold by holding up a $20 St. Gaudens double-eagle gold coin. Prior to 1933, Americans carried this coin in their pockets as money. Back then, they could buy a tailormade suit for one double eagle, or $20. Today this same coin–which is worth between $400 and $600, depending on its rarity and condition-could buy the same tailor-made suit. Of course, the double-eagle coin has numismatic, or rarity, value. A one-ounce gold-bullion coin, without numismatic value, is worth only around $300 today. Gold has risen substantially in dollar terms but has not done as well as numismatic U.S. coins.

Gold as an Inflation Hedge

The price of gold bullion was over $800 an ounce in 1980 and has steadily declined in value for nearly two decades. Does that mean it’s not a good inflation hedge? Indeed, the record shows that when the inflation rate is steady or declining, gold has been a poor hedge. The yellow metal (and mining shares) typically responds best to accelerating inflation. Over the long run, the Midas metal has held its own, but should not be deemed an ideal or perfect hedge. In fact, U.S. stocks have proven to be much profitable than gold as an investment.

The work of Jeremy Siegel, professor of finance at the Wharton School of the University of Pennsylvania, has demonstrated that U.S. stocks have far outperformed gold over the past two centuries. Like Jastram, Siegel confirms gold’s long-term stability. Yet gold can’t hold a candle to the stock market’s performance. As the chart, taken from his book, Stocks for the Long Term, shows, stocks have far outperformed bonds, T-bills, and gold. Why? Because stocks represent higher economic growth and productivity over the long run. Stocks have risen sharply in the twentieth century because of a dramatic rise in the standard of living and America’s free-enterprise system.

One final note: Stocks tend to do poorly and gold shines when price inflation accelerates. As Siegel states, “Stocks turn out to be great long-term hedges against inflation even though they are often poor short-term hedges.”2 Price inflation is the key indicator: When the rate of inflation moves back up, watch out. Stocks could flounder and gold will come back to life. In my next column, I’ll discuss the ability of gold to predict inflation and interest rates.

When speaking of the Midas metal, I’m reminded of Mark Twain’s refrain, “The reports of my death are greatly exaggerated.” After years of central-bank selling and a bear market in precious metals, the Financial Times recently declared the “Death of Gold.” But is it dead?

Following the Asian financial crisis last year, Mark Mobius, the famed Templeton manager of emerging markets, advocated the creation of a new regional currency, the asian, convertible to gold, including the issuance of Asian gold coins. “All their M1 money supply and foreign reserves would be converted into asians at the current price of gold. Henceforth asians would be issued only upon deposits of gold or foreign-currency equivalents of gold.” Mobius castigated the central banks of Southeast Asia for recklessly depreciating their currencies. As a result, “many businesses and banks throughout the region have become bankrupt, billions of dollars have been lost, and economic development has been threatened.” Why gold? “Because gold has always been a store of value in Asia and is respected as the last resort in times of crisis. Asia’s history is strewn with fallen currencies. … The beauty of gold is that it limits a country’s ability to spend to the amount it can earn in addition to its gold holdings.”

Not Just Another Commodity

Recent studies give support to Mobius’s new monetary proposal. According to these studies, gold has three unique features: First, gold provides a stable numeraire for the world’s monetary system, one that closely matches the “monetarist rule.” Second, gold has had an amazing capacity to maintain its purchasing power throughout history, what the late Roy Jastram called “The Golden Constant.” And third, the yellow metal has a curious ability to predict future inflation and interest rates.

Let’s start with gold as a stable monetary system. With most commodities, such as wheat or oil, the “carryover” stocks vary significantly with annual production. Not so with gold. Historical data confirm that the aggregate gold stockpile held by individuals and central banks always increases and never declines.2 Moreover, the annual increase in the world gold stock typically varies between 1.5 and 3 percent, and seldom exceeds 3 percent. In short, the gradual increase in the stock of gold closely resembles the “monetary rule” cherished by Milton Friedman and the monetarists, where the money stock rises at a steady rate (see Chart I).

Compare the stability of the gold supply with the annual changes in the paper money supply held by central banks. As Chart II indicates, the G-7 money-supply index rose as much as 17 percent in the early 1970s and as little as 3 percent in the 1990s. (Why has monetary growth slowed even under a fiat money standard? The financial markets, especially the bondholders, have demanded fiscal restraint of their governments.) Moreover, the central banks’ monetary policies were far more volatile than the gold supply. On a worldwide basis, gold proved to be more stable and less inflationary than a fiat money system.

Critics agree that gold is inherently a “hard” currency, but complain that new gold production can’t keep up with economic growth. In other words, gold is too much of a hard currency. As noted the world gold stock rises at a miserly annual growth rate of less than 3 percent and oftentimes under 2 percent, while 70% GDP growth usually exceeds 3 or 4 percent and sometimes 7 or 8 percent in developing nations. The result? Price deflation is inevitable under a pure gold standard. My response: Critics are right that gold-supply growth is not likely to keep up with real GDP growth. Only during major gold discoveries, such as in California and Australia in the 1850s or South Africa in the 1890s, did world gold supplies grow faster than 4 percent a year.3

Prices Must Be Flexible

Consequently, an economy working under a pure gold standard will suffer gradual deflation; the price level will probably decline 1 to 3 percent a year, depending on gold production and economic growth. But price deflation isn’t such a bad thing as long as it is gradual and not excessive. There have been periods of strong economic growth accompanying a general price deflation, such as the 1890s, 1920s, and 1950s. But price and wage flexibility is essential to make it work.

Next month. Update on Jastram’s study The Golden Constant, and gold’s amazing ability to maintain its purchasing power over the past 400 years.

1. Mark Mobius, “Asia Needs a Single Currency,” Wall Street Journal, February 19, 1998,p. A22.
2. See the chart on page 84 of my Economics of a Pure Gold Standard, 3rd ed. (1997), available from FEE. Note how the world monetary stock of gold never has declined between 1810 and 1933.
3. Ibid., p X6.

“[Austrian economists] feel they’ve been frozen out of mainstream economics and seldom get even a footnote in standard textbooks.”
-Todd G. Buchholz 1

Austrian economist makes good! I just got published in the Journal of Economic Perspectives, the most widely read economics journal in the country.

The article, “The Perseverance of Paul Samuelson’s Economics,” is a damning review of the 15 editions of Samuelson’s famous textbook2 I am still in shock a year after getting an email from the JEP saying they had accepted my paper. Undoubtedly it is a watershed event when the No. 1-read economics journal in the country is willing to publish an article critical of the top Keynesian economist in the world and first American to win the Nobel Prize in economics. One of the co-editors, Brad de Long, said that my study is “one of the best and most exciting papers we published in the second half of the 1990s.” Tim Taylor, the managing editor, said that ten years ago they would not have published it.

Dethroning the King of Keynes

There are two major stories that come out of my study.

First, Samuelson’s Economics–the most popular textbook ever published, with over four million sold and translated into 41 languages–taught students a lot of bad economics. Until recently, the MIT professor taught students that high saving rates were bad for the country, federal deficits and progressive tax rates were beneficial, and Soviet central planning could work. In my review of his 15 editions, which covers the entire postwar period, I point out that Professor Samuelson spent whole chapters discussing the failed economics of the Soviet Union and China, while writing little or nothing on the success stories of West Germany, Japan, the East Asian Tigers, or Chile. He had numerous sections in his textbook on “market failure” while offering very little on “government failure.” He constantly highlighted the economics of Keynes, but downplayed the economics of Friedman, Hayek, and other free-market economists.

Samuelson’s Economics: From Keynes to Adam Smith

Not everything was negative in my review of Samuelson’s textbook. On the positive side: Samuelson frequently declared his optimism about the future of capitalism and rejected doomsayers’ predictions of another Great Depression or national bankruptcy. He regularly defended free trade and free markets in agriculture. And he was highly critical of Karl Marx and Marxian economics.

The most amazing discovery I made in my study is that Samuelson, under the influence of co-author William D. Nordhaus (Yale) and recent events, has had a change of heart and is gradually shifting back to classical economics. In more recent editions, he has reversed his position on a number of important issues. In the most recent edition, for example, Samuelson states that Soviet central planning was a “failed” model, that national savings is too low and needs to increase, and that the national debt is excessive.

The JEP also published a rejoinder by Samuelson, which was surprisingly reserved and anemic in response to my blistering critique. “I am pleading no alibi nor extenuations,” he wrote. “My present-day eyes do discern regrettable lags in sloughing off earlier skins.”3 He only denied that he was anti-saving, one thing he is famous for.

My study of Samuelson’s Economics points to the real need for a college-level textbook on sound economics. That is my primary goal right now. My forthcoming textbook is called Economic Logic and I hope to finish it next year. I’11 keep you posted.

Past Prejudices Against Austrians

Austrian economists have had a long struggle in getting recognized by the profession. The mainstream has shown little interest if not disdain for a school that is laissez faire in government policy and critical of mathematical modeling and empirical econometrics.

Following the postwar Keynesian revolution, the economics establishment was unreceptive to the works of Ludwig von Mises and Friedrich Hayek. In the 1960s, Austrian economists depended on the conservative publisher Regnery and the engineering publisher D. Van Nostrand & Co. to get published.

Future Is Brighter

Gratefully that’s all changing. Today Austrians hold a small but growing number of positions at major universities (George Mason, Auburn, NYU, University of Georgia, California State at Hayward, etc.), get published by major university and academic presses (Cambridge, Chicago, Oxford, NYU, Kluwer, Routledge, and Edward Elgar, among others), and are getting accepted in major journals (Journal of Economic Literature, History of Political Economy, Journal of Macroeconomics, and Economic Inquiry).

Still, other “free-market” schools (the monetarists and the new classicists) have advanced much further because of their mathematical and empirical approach. The Austrian school still largely remains a “book culture,” as Peter Boettke puts it, and needs to devote more efforts to “strategic” publishing in the journals rather than preaching to the choir if it wants to have an impact.4 Happily, things are looking up.

What?! The world’s most famous freemarket economist a former Keynesian?

Yes, it’s true. One of the more remarkable revelations in Milton and Rose Friedman’s new autobiography, Two Lucky People, is Milton Friedman’s flirtation with Keynesian economics in the early 1940s. During his stint with the Treasury Department, Friedman was asked to give testimony on ways to fight inflation during World War II. His reply, couched in Keynesian ideology, mentioned several options: cutting government spending, raising taxes, and imposing price controls. Amazingly, nowhere did he mention monetary policy or controlling the money supply, the things Friedman is famous for today.

During the 1930s, Friedman had also favored Keynesian-style deficit spending as a way out of the Great Depression. His mentor was not Keynes himself but Friedman’s teachers at the University of Chicago. Friedman recounts, “Keynes had nothing to offer those of us who had sat at the feet of [Henry] Simons, [Lloyd W] Mints, [Frank] Knight, and [Jacob] Viner.” 2 In short, Chicago economists were Keynesian before Keynes.

In his autobiography, Friedman says he was “cured” of Keynesian thinking “shortly after the end of the war,” but doesn’t elaborate. In a recent letter, he denies ever being a thorough Keynesian. “I was never a Keynesian in the sense of being persuaded of the virtues of government intervention as opposed to free markets.” It should also be pointed out that Friedman’s teachers at Chicago blamed the Great Depression on “misguided government policy.” Friedman indicates he was “hostile” to the Keynesian idea that the Depression was a market phenomenon. 3

Despite these statements, many free-market economists have long accused Friedman of being a quasi-Keynesian.

On December 31, 1965, Time magazine put John Maynard Keynes on the cover and quoted Friedman as saying, “We are all Keynesians now.” Later, Friedman said he was quoted out of context. “In one sense, we are all Keynesians now; in another, no one is a Keynesian any longer. We all use the Keynesian language and apparatus, none of us any longer accepts the initial Keynesian conclusions.” 4

In an article published in 1986, Friedman glorified Keynes as a “brilliant scholar” and “one of the great economists of all time.” He described The General Theory as a “great book,” although he considers his Tract on Monetary Reform as his best work. Moreover, he declared, “I believe that Keynes’s theory is the right kind of theory in its simplicity, its concentration on a few key magnitudes,its potential fruitfulness.” 5

Many conservatives wonder how Milton Friedman, defender of free markets, could speak so highly of a man considered the intellectual architect of the postwar inflation and the modern welfare state.

Friedman is known as the leader of the Monetarist opposition to the Keynesian revolution. According to Friedman, monetary policy (manipulation of the money supply and interest rates) influences economic activity far more than fiscal policy (taxes and government spending). Yet it must be remembered that monetary and fiscal policies are both forms of state intervention in the economy. Accordingly, some free-market advocates see Keynes and Friedman as partners in crime.

Granted, Friedman, as opposed to the Keynesians, favors a strict limit on monetary growth. Yet even Friedman occasionally succumbs to interventionist fever. Late last year he endorsed this remedy for Japan’s sluggish economy: print more money. Apparently Friedman felt that the easy-money policy in effect in Japan since 1994 (recent M1 was growing at 9.9 percent, M2 at 4.3 percent) was insufficient. “The surest road to a healthy economic recovery,” he wrote, “is to increase the rate of monetary growth.” What about tax relief, deregulation, and open markets? Friedman failed to list any of these options. 6

Undoubtedly he favors these remedies, but the article rekindled the old accusation that “only money matters” to Friedman.

Friedman the Anti-Keynesian

I have to admit that, like many free-market economists, I am surprised by these findings and the favorable comments Friedman has made about Keynes. I’ve always viewed the leader of the Chicago school as strongly anti-Keynesian. His Monetary History of the United States clearly contradicts Keynes’s contention that the capitalist system is inherently unstable. 7 The book shows that the Fed’s inept policies, not free enterprise, caused the Great Depression. Friedman’s permanent-income hypothesis modifies Keynes’s consumption function and undermines the case for progressive taxation. His natural-rate-of-unemployment doctrine denies any long-run trade-off between inflation and unemployment (the Phillips curve). In Capitalism and Freedom, Friedman challenges the effectiveness of the Keynesian multiplier and declares that the federal budget is the “most unstable component of national income in the postwar period.” 8 And, as early as 1963, he labeled as “erroneous” the Keynesian proposition that the free-market economy can be stuck indefinitely at less than full employment. 9

So where does that leave us? In one of the more controversial contributions to my edited volume Dissent on Keynes, Roger Garrison of Auburn University asks, “Is Milton Friedman a Keynesian?” Garrison contends he can argue it either way. Indeed. Yet, in the final verdict, I can’t help but think that Friedman, as an open-minded scholar, is willing to investigate and test all theories, no matter their source, and this methodology has gradually led him to discard most of Keynesianism. As he himself has written, “I have been led to reject it… because I believe that it has been contradicted by experience,” 10

1. Milton and Rose Friedman, Two Lucky People (Chicago: University of Chicago Press, 1998), p. 113.

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